The world oil market has undergone tremendous changes in the past three
decades, starting from the renegotiation of the “posted price”—a
reference price on which royalties to host countries were calculated—in
1970. Before that, this price was fixed (at US$1.80 a barrel during the
1960s) by the major international oil companies that operated the oil
concessions in these countries. Subsequent events culminating in the 1973
oil price shock and the eventual transfer of property rights to the host
countries heralded the start of a new era in the oil industry.

Middle Eastern countries—through their role in the Organization
of the Petroleum Exporting Countries (OPEC)—were at the center of
the transformation of the market since they owned the bulk of world proven
crude oil reserves. In addition to transforming their societies through
the inflow of substantial amounts of oil revenue, the Middle Eastern and
North African (MENA) countries encountered new challenges in the area
of economic policy and management, including how to cope with the adverse
impact of the variability of oil prices on growth. The primary focus of
this pamphlet is the developments in the international oil market, the
role of Middle Eastern countries therein, and the policy challenges arising
from this dependency on oil.

Evolution of the Oil
Market

The series of oil price increases in 1973–74 marked a distinct era
for the oil market because it coincided with the transfer of property
rights to the host countries from the major oil companies that had operated
the industry in an integrated framework up to that time. Until 1973, the
price of crude oil was determined by the major oil companies in an oligopolistic
market arrangement, under which a “posted price” was established,
with royalties and taxes paid to host governments on the basis of this
price. In June 1968, OPEC had published a Declaratory Statement of
Petroleum Policy in Member Countries (Resolution XVI.90) in which
members resolved to work toward greater control over their resources and
increased share of their petroleum assets. Although this event was largely
dismissed at the time as another ineffectual move by OPEC to wrest control
from the international oil companies, analysts were later to acknowledge
the importance of the Declaration. Griffin and Teece (1982, p. 7) wrote
that “. . . though this doctrine was not taken seriously at the time,
the events of the early 1970s prove it was an accurate blueprint for events
to come.”

Era of Price Fixing: Balanced to Tight Market Period

Following the events of 1973–74, the determination of the crude
oil price passed largely into the hands of OPEC, which carried out this
function by setting an official selling price for the best known among
its crudes, the Arab light, and leaving individual members to adjust their
selling price in relation to this marker according to the quality of the
oil—the American Petroleum Institute (API) rating, sulfur content,
etc. The marker crude oil price–setting announcement was usually
accompanied by production quota allocations to the members of the organization,
with the principal objective of matching supply to demand after due allowance
was made for non-OPEC production. The system worked relatively well until
the early 1980s, eventually falling victim to its own success.

The high oil price level in the second half of the 1970s, following the
events of 1973–74, encouraged exploration and production in high-cost
oil regions, such as the North Sea, Canada, Mexico, and elsewhere. Of
these, developments in the North Sea were probably the most dramatic.
Total output from (Western) Europe was less than 0.5 million barrels a
day (Mb/d) during the decade up to 1974. Growth accelerated from 1975
onward, as North Sea fields became profitable in the light of the (OPEC-induced)
higher oil prices, compounded by favorable upstream tax incentives for
oil companies. By 1985, production levels had reached 3.8 Mb/d, almost
doubling again to 6.7 Mb/d by 2002, largely because of new technologies
that enabled new high-cost fields to be profitably developed and that
lowered production costs generally. OPEC’s market share was gradually
eroded as rising non-OPEC output more than absorbed the incremental demand
and forced the organization to undertake successive cycles of quota cuts
in a futile attempt to defend the price. Indeed, OPEC was successful for
quite some time in setting the price while also controlling the output
of its members largely because demand for OPEC oil was sufficiently buoyant
relative to supply; a monopoly (or quasi-monopoly) cannot control both
the output and price of its product.

The MENA countries were at the forefront of these developments. Aside
from the use of Arab light as the benchmark crude, Saudi Arabia and other
major MENA producers played the role of swing supplier, adjusting output
up and down as necessary to balance the market; for example, they raised
output during the Iranian revolution and lowered output when the market
was oversupplied. OPEC eventually abandoned the swing supplier role in
1985 in an attempt to regain some of its market share.

An analysis of the circumstances that enabled OPEC to successfully control
the oil price in the 1970s and early 1980s reveals the changes the oil
market has undergone and why oil-dependent countries, including those
of the Middle East region could no longer take any level of income from
the oil sector for granted. This inability to rely on oil revenue also
underlines the necessity of accelerating the pace of economic reforms
and economic diversification. The main features of the oil market during
that period can be summarized as follows.

Global oil demand grew by almost 10 percent between 1976 and 1979,
following a dip in 1974 and 1975, as the world economy returned to a
growth path; this comfortable growth rate made it possible for OPEC
to accommodate its members’ behavior, including their overproduction.
OPEC’s quota policy, though only partially successful, forced the
oil market into a state of near equilibrium. The Iranian revolution
in 1979 resulted in the loss of output from that country, which, combined
with speculative behavior on the part of market agents, led to a doubling
of oil prices in 1979–80. This price effect, along with weakening
world economic growth, resulted in a fall in global oil demand by 4.5
percent in 1980 and a further 3 percent in 1981.

More important, supplies from non-OPEC sources in the 1970s were
much smaller than their present levels. The high average cost of production
from principal non-OPEC sources, mainly the North Sea (about $15 a barrel
or more), acted as a constraint on growth from these sources. Consequently,
their share of the incremental demand was small enough not to undermine
the market or threaten OPEC’s dominant position. With the decline
in production costs, owing to the deployment of new exploration and
production technologies, such as three-dimensional and subsea completion
methods, the situation changed and the OPEC grip on the market weakened
considerably.

Technical innovations in the industrial, commercial, transportation,
and household sectors were still at an early stage and, although there
was evidence of declining energy intensity, the full impact was to become
clear only in the 1980s, following years of incremental efficiency gains.
This meant a decline in the amount of energy required to produce a given
amount of GDP, thereby constraining the overall growth in energy demand.

The system of international oil trade at the time was based largely
on term contracts, with prices and volumes being negotiated on a quarterly
basis. This provided the market with an identifiable benchmark over
a known period; the spot market played mostly a balancing role, as well
as serving as an indicator of the degree of stress, if any, in the market.
The acceptability of the OPEC-driven pricing system was enhanced because
it provided a predictable benchmark, which was appreciated by agents
on both sides of the market in terms of their economic planning and
investment decisions.

The acceptability of the OPEC pricing approach appeared to have had
theoretical backing as well. The prevailing wisdom in the oil industry
during the 1970s, supported by contemporary research (e.g., Pindyck,
1978) was that the price of oil would display intertemporal increases
because of its exhaustible character—following a Hotelling path
(Hotelling, 1931). Although there was no unanimity on pricing in the
oil literature at the time (e.g., Adelman, 1974, 1982), this may inadvertently
have had the effect of justifying the OPEC price-setting practice and
lulled major oil exporters into a false sense of confidence about the
future of oil prices, thereby delaying needed economic reforms. However,
since the 1980s, the price of oil has declined not only in real terms,
but also in nominal terms (see Figure 1).

In summary, the circumstances prevailing in the oil market in the 1970s
were favorable to OPEC, which used the opportunity to set prices at levels
that the existing conditions would permit. Market conditions have changed
significantly since then; OPEC has lost some market power, owing to price-induced
non-OPEC output increases, and oil revenues have since become more difficult
to predict.

Drive for Market Shares: From Control to Free Market Price Determination

With the persistent loss of market share in the first half of the 1980s,
the leading MENA oil producers spearheaded a change of strategy within
OPEC, which opted for defending a market share and allowing the price
to be determined by market forces. In the event, the ensuing price war
resulted in the predictable price collapse by July 1986 to under $10 a
barrel, from about $28 a barrel in December 1985. As demand growth resumed,
coupled with supply restraint by major producers, the price recovered
somewhat before rising sharply as a result of the Middle East crisis of
1990–91. However, the struggle for market shares between OPEC and
non-OPEC producers on the one hand, and among OPEC members on the other,
ensured continued market weakness through most of the 1990s, culminating
in the price collapse of 1998 when the oil price again fell to about US$10
a barrel. The loss of market influence by OPEC (and MENA) producers was
compounded by the increasing prominence of the oil spot and futures markets,
which now formed the basis of oil pricing, rather than OPEC setting it—as
formula pricing that linked contracts to spot and futures prices became
the order of the day. (See, among others, Verleger, 1993, for a discussion
of the rise and role of futures trading in oil.)

With widening fiscal and external current account deficits, the key MENA
oil producers, through OPEC, pushed for a reintroduction of the quota
system (and a target price) following the 1986 price collapse. However,
this had limited success during most of the 1990s, primarily because of
difficulties in forecasting world demand, non-OPEC output, and maintaining
quota discipline among its members. With the loss of market control by
OPEC, the excess supply of 1998 caused the price to collapse to levels
dictated by market fundamentals. The authorities in the region responded
by introducing expenditure cuts, mostly on capital outlays, but this also
led to serious consideration being given to reforms. The world oil market
has recovered since mid-1999, driven by a combination of low global inventories,
increased cooperation between OPEC and non-OPEC producers on output restraint,
improved quota discipline among OPEC members, oil sector strikes in key
producing countries, and geopolitical developments in the Middle East.
This has enabled oil exporters, including those of the MENA region, to
earn substantial revenues and build up foreign reserves. It remains to
be seen how well they use this window of opportunity to achieve their
reform objectives.

Demand-Side Factors

The price increases of the 1970s and early 1980s had serious effects
on the behavior of demand—after a lag. In response to the high oil
price increases of that time, oil demand growth slowed considerably, rising
by an average of just 0.65 percent a year between 1975 and 1985, but recovered
to 1.5 percent growth rate a year in the 1990s—mostly reflecting
the high world economic growth at the time.

These changes were also manifested in improvements in energy efficiency—driven
first by the higher crude oil prices and later by high end-user taxes
on petroleum products. Economies have become more flexible in adapting
to changing oil prices. In surveys of elasticities based on data from
the 1960s up to more recent years, Sterner (1991), Goodwin (1992), and
Graham and Glaister (2002), among others, found that elasticity estimates
for petroleum products were higher in those studies that used data covering
more recent years. Aside from differences stemming from different model
specifications, coverage, and methodologies, a major explanation for this
observation appears to be that market agents have had sufficient time
to adapt to the oil price increases through fuel switching and deployment
of more efficient capital stock. Another reflection of this is the fact
that energy intensity—defined as energy consumption per unit of output—has
declined by about 1.1 percent a year since the 1970s owing to a secular
shift from heavy to lighter industries and to efficiency gains. Similarly,
there have been huge fuel efficiency gains in the automobile industry,
following such developments as the change in body design for improved
aerodynamics and the introduction of fuel injection technology.

These developments were directly reflected in a decline in OPEC (and
Middle Eastern) market share and influence, because oil supplies from
these countries have been treated as residual to the market since the
mid-1970s. This means that major consumers turned to these countries to
meet the balance of their requirements only after procuring oil from non-OPEC
sources. OPEC supplied about 49 percent of world oil requirements in 1975
but this share fell to just 30 percent by 1985. OPEC’s supply share
has gradually recovered over the years and now stands at about 37 percent
(if Natural Gas Liquids—NGLs—are included). In general, in spite
of losing some ground, Middle Eastern producers continue to occupy center
stage in oil market developments, occupying 5 of the top 10 spots among
oil exporters in 2002 (see Figure 1), and this situation
will likely continue into the foreseeable future given their large proven
reserves and spare capacity (see Okogu, 2003).

The Middle East in the Global Oil Balance

The MENA region, through its dominance of world oil reserve ownership,
occupies a central position in the global energy balance—quite apart
from its substantial gas reserves, although the latter is not yet well
developed. Even with the loss of ground to other energy carriers, oil
(and the region) will continue to play a core role in the future of world
energy.

Oil in the Global Energy Balance

The prestige of Middle Eastern countries in world energy markets stems
primarily from their role in the oil market, even though the region also
owns substantial reserves of natural gas. Their fortune is thus directly
related to how well oil holds its share vis-à-vis other forms of
energy in the evolving global energy balance. Over the years, starting
with the sharp price increases of the 1970s, it has lost some ground to
other fuels. The continued strength of oil in global energy stems from
its dominance of the transportation sector, where it now accounts for
about 96 percent of the market. It also accounts for 27 percent in the
industrial sector and 9 percent in power generation—having lost ground
to coal, gas, and nuclear power in these sectors (see International Energy
Agency, 2001, 2002, for more details). The rate of substitution away from
oil is directly related to how technically feasible such changes are and
to the availability of cost-effective substitutes, which explains why
oil has continued to dominate the transportation sector, where efforts
to introduce alternatives have so far had limited success.

In contrast to oil, the share of natural gas in total primary energy
has been on the increase; it rose from 18 percent to about 23 percent
between 1973 and 2001, spurred by a combination of higher oil prices,
the need for energy self-sufficiency in the major consuming countries,
and diversification, as well as recent environmental concerns relating
to global warming and climate change. Natural gas is the least carbon-intensive
of the fossil fuels, followed by oil and then coal (see, among others,
Mitchell, 2000, for a brief discussion of the environmental dimension
of fuel use in the context of ongoing negotiations on climate change).
The use of natural gas has also increased as a result of secular growth
in the petrochemical industry, where it is the main feedstock for a wide
variety of petrochemical products.

There are indications that the gas industry in the Middle East is underinvested
because its share of the world output (at about 14 percent) is much lower
than its share of reserves (40 percent). An illustration of this can be
seen from the fact that although Iran owns the world’s second-largest
reserves (15.3 percent of total) after Russia, it produces only about
2 percent, and indeed, imports some gas from neighboring Turkmenistan
(4.9 billion cubic meters in 2002). Projections of demand for natural
gas up to 2020 by the International Energy Agency (IEA, 2002) suggest
continued gains for gas in the global energy balance, while oil is expected
to just maintain its present share.

Middle East Oil and Gas Resource Endowments

The Middle Eastern region is abundantly endowed with oil and gas resources.
Of the 1,050 billion barrels of proven crude oil reserves at end-2001,
the MENA region accounted for about 69 percent. In contrast, the region
accounted for just about 31 percent of total world production, and about
50 percent of exports, which clearly demonstrates the centrality of the
region to the present and future of the global oil market (see Figure
1). Although new oil reserves continue to be discovered and developed
in various countries, such as in the countries of the former Soviet Union
and in offshore West Africa, most forecasts indicate that dependence on
Middle Eastern oil will increase in the coming years, as production starts
to decline in the key North Sea basin and elsewhere.

Unlike oil, natural gas reserves are more widely dispersed around the
world, with the Middle East accounting for about 40 percent of total world
reserves of 155 trillion cubic meters. In 2002, gas production from the
region accounted for about 14 percent of total world output, in part reflecting
the relative underinvestment in the gas sector of the region mentioned
earlier. This is, however, changing: the US$25 billion Saudi Gas Initiative,
ongoing or planned production expansion by Algeria, Qatar, and Oman, and
expected developments in Iran, Libya, and Yemen should substantially raise
Middle Eastern gas output in the coming years. The infrastructure needed
to support the gas industry (pipeline gas and liquified natural gas (LNG))
is quite costly, and partly explains the difficulty in developing a global
gas market and the relatively low development of the MENA gas sector.
Nevertheless, the region is becoming an important player in the gas trade,
accounting for about 8 percent of pipeline gas exports and 40 percent
of LNG exports in 2002 (see Okogu, 2002, for more details).

As part of the region’s efforts toward industrialization, and to
increase the value added to the oil sector, many Middle Eastern oil producers
have built their own refineries, alone or in partnership with international
oil companies. As of 2001, the refinery capacity in the region amounted
to about 10 percent of the world’s total capacity of about 82 Mb/d
and about 30 percent of world exports of refined products.

Projections of Demand
for Middle East Oil and Gas

Present projections of global oil demand suggest that world requirements
would rise to 92 Mb/d by 2010 and to 110 Mb/d by 2020 (see International
Energy Agency, 2002, for example) from the 2002 level of 77 Mb/d. This
may, however, be too optimistic. On the assumption that demand grows by
an average of 1 percent a year up to 2020, this author projects world
demand at 83 Mb/d by 2010 and 91 Mb/d by 2020. Of this, the call on OPEC
crude oil (not counting NGLs, which is presently 3.6 Mb/d) would be about
27 Mb/d and 36 Mb/d in 2010 and 2020, respectively, based on the assumption
that the OPEC market share for crude oil would rise to about 35 percent
by 2010 and to 40 percent by 2020 from the current level of 33 percent.
This growing market share for OPEC is premised on the fact that non-OPEC
reserves are declining, though expected to still be quite resilient up
to 2010, given the reality that they have largely produced at full capacity
from their limited reserves over the past several decades. Within OPEC,
MENA members own about 88 percent of the reserves and currently produce
about 77 percent of the group’s output. Given that some of the non-MENA
OPEC countries are producing at close to full capacity, it is evident
that the Middle Eastern members would increase their share of the group’s
output, but this pamphlet assumes that their share of OPEC’s output
remains unchanged. This would mean an increase in MENA output to about
31 Mb/d (or 34 percent of world oil supply) by 2020. Even if the oil price
were to remain at US$18–21 a barrel in real terms—which many
analysts consider the long-term price—this should ensure substantial
financial inflows into the region in the coming years.

There are, however, downside risks, including those relating to possible
new oil discoveries in other regions and the possibility of obsolescence
in the event of cost-effective technological breakthroughs that bring
cheap alternatives onto the market, for example, in the transportation
sector. Regarding possible discoveries, the decline of non-OPEC production
has continuously been predicted and subsequently revised since the 1980s
as new discoveries and technological advancement have extended the life
of non-OPEC fields. As for cost-effective technological breakthroughs,
research is ongoing in a variety of areas, with a view to improving both
the performance and cost-effectiveness of fuel cell technology, natural
gas–powered vehicles, electric vehicles, etc. Such research was given
a boost by the requirement introduced by the state of California in the
1990s that at least 10 percent of automakers’ new models be zero-emission
vehicles (ZEVs) by early this decade. Such cars, which rely on electricity
and other zero-emission energy carriers, presently have the disadvantage
of limited range and speed as well as high costs. However, improvements,
which have also improved the market acceptability of these vehicles, continue
to be made. While it is difficult to predict the degree of market penetration
of ZEVs by 2020, developments in this area will clearly be critical for
the future of oil since the transportation sector is the only area where
petroleum products still have no serious competition.

It is therefore imperative that oil-exporting MENA countries expedite
necessary reforms that are already planned or under way. Indeed, even
if the oil market were to turn out as favorable to the region by 2020
as currently projected, reforms would still be necessary in the transition
because medium-term projections indicate a declining trend in the oil
price. This could be compounded by an expected increase in Iraqi oil exports,
as the oil sector infrastructure is rehabilitated and new investments
are made in Iraq’s upstream oil sector (exploration, development,
and production of oil). Besides, although the oil sector is a good source
of financial inflows, its role as a provider of jobs is relatively limited,
being capital intensive and an enclave sector. For a general assessment
of unemployment issues in the MENA region, see Gardner (2003).

Challenges Facing Middle Eastern Oil and Gas Producers

A number of challenges face the MENA countries, some relating to the
oil industry itself, and others concerning the economic management of
the oil wealth. Aside from the need for a large capital infusion into
the industry, MENA countries have the additional challenge of using the
sector as a vehicle for increasing intraregional trade. The most important
challenge, however, lies in designing appropriate macroeconomic policies
to ensure that the oil wealth is managed effectively.

Investment Challenges

The capital intensity of the oil and gas sector means the sector requires
regular injections of investment capital in exploration, development,
production, and maintenance to replace produced oil and protect the integrity
of the wells. These investments are being met in the MENA countries mostly
from the internal resources of the national oil companies but also by
tapping the international capital market (as in the case of Qatar LNG
projects), and through foreign direct investment (as in the case of Sudan).
Most of the countries prohibit foreign equity participation in the upstream
oil sector but some allow production-sharing arrangements (e.g., Qatar).

There are also innovative investment arrangements, such as the Saudi
Gas Initiative. The projects have experienced delays owing to difficulties
in reaching agreement between the government and international oil companies.
However, the authorities are determined to proceed with the Initiative,
and have reportedly repackaged the projects and invited fresh bids from
international investors. Under the original plan, the investing companies
were to explore for and produce gas for use in downstream projects (water
desalination, electricity generation, and petrochemicals), with the investment
coming from these companies. It is estimated that the projects will cost
US$25 billion over 10 years, and produce 300 million gallons of water
a day, 2 million tons of petrochemicals a year, and 4,000 MW capacity
of electricity. Other investment opportunities will come from ancillary
projects, mostly in the form of supporting infrastructure. The investment
challenge in the MENA region will involve policy changes, probably as
an integral part of a wider structural reform program designed to attract
foreign direct investment.

Challenge of Increasing Regional Energy Trade Through Integration

Energy integration across the region is another challenge, which authorities
in some of the countries are working on. For example, plans are under
way for energy integration in the GCC area designed to take advantage
of the synergy afforded by the differential in resource endowments and
energy needs in the various countries. In this regard, a pipeline system
will be constructed to transport gas from Qatar—which has the world’s
third-largest natural gas reserves—to Kuwait, the United Arab Emirates,
and Oman, with the option of taking it further afield to Pakistan and
beyond. This would dramatically increase intraregional trade by creating
an immediate market for Qatari gas in neighboring countries that are seeking
to procure more gas for their power and petrochemical industries. Although
some of these other countries also possess their own gas reserves, these
are largely in the form of associated gas (i.e., produced as a side-product
of oil), which means that the production of gas is constrained by OPEC
oil quota obligations. If this project is successful it could form the
nucleus of a wider cooperative energy arrangement extending beyond the
GCC countries.

Challenge of Wealth and Economic Management

Perhaps the most important challenge facing MENA oil-producing countries
is how best to manage their oil wealth taking into account its exhaustible
character and with due attention to intergenerational equity, given their
dependency on a depleting natural resource. This essentially requires
fiscal policy that ensures the preservation of the oil wealth’s value.
This could be achieved by the government limiting consumption to the permanent
income from the total wealth. However, the size of the oil wealth—and
hence the size of the permanent income—cannot be estimated with certainty
because some of the critical variables, such as size of reserves, future
oil prices, and cost of production, are not, by their very nature, known.
Estimating the size of the hydrocarbon wealth and designing appropriate
policies to optimize that wealth for the benefit of present and future
generations roughly encapsulates the nature of the challenge currently
facing MENA oil-dependent economies. Decision-making under uncertainty,
assuming risk-averse behavior, requires the government to be conservative
in its fiscal policy orientation. This could mean using a conservative
oil price path for the calculation of permanent wealth, as well as focusing
on the non-oil fiscal balance to assess fiscal sustainability.

Given the exhaustible nature of oil, the aim should be to accumulate
a sufficient stock of financial assets that the flow of income from those
assets can finance the non-oil fiscal deficit after the exhaustion of
the oil reserves or, indeed, during periods of prolonged decline in the
oil price. A more stringent fiscal rule for oil-dependent economies has
also been proposed. The so-called “bird-in-hand” approach proposes
that the projected income should be the return on financial assets already
in hand rather than estimated income from future wealth (see Barnett and
Ossowski, 2002, 2003, for more detailed discussions of these issues).
The main advantage of this model is that it removes some of the elements
of uncertainty from the planning process. It protects the economy from
the risk of possible obsolescence of the type discussed earlier in connection
with the possibility of alternative fuels displacing oil, and therefore
has the effect of forcing the government to be even more fiscally responsible.
Obsolescence in this case means not necessarily that oil usage would be
obsolete, but that if technological advancement makes alternative fuels
competitive in the energy market, the price of these alternatives may
become so low that it would no longer be cost-effective to produce and
use oil for the same purpose. The challenge of wealth management would
be even more daunting if these countries aim to maintain their per capita
wealth, given the rapid population growth rates in the region.

In MENA countries, non-hydrocarbon fiscal balances vary quite a bit (see
Table 1), just as the size of the oil reserves and
foreign assets vary. Some countries, such as Kuwait, have built up dedicated
financial assets for intergenerational equity purposes, while others have
oil stabilization funds (for example, Libya, Oman, and Qatar). However,
in all cases, the emphasis in the region is increasingly on reforms to
strengthen the structure of the budget both from the revenue side and
from improved expenditure management; structural reforms designed to broaden
the operational space of the private sector and attract foreign direct
investment; and labor market reforms to upgrade the skills of the workforce.

In terms of economic diversification, the abundance of oil and gas reserves
in the region could be seen as a mixed blessing. The sector has been a
source of large fiscal revenue and foreign exchange earnings that have
facilitated the implementation of huge infrastructure projects and enabled
these societies to build foreign assets and attain a high standard of
living. Indeed, it has afforded some of them the wherewithal to extend
generous financial aid to other developing countries. In this regard,
individual development funds have been set up by some MENA countries,
such as Saudi Arabia and Kuwait, which also set up multilateral financial
institutions in collaboration with other countries, such as the Islamic
Development Bank and the OPEC Fund for International Development.

However, the large oil resources have also meant excessive dependence
on a single sector, with the attendant downside risks from oil price fluctuations.
Over the years, most oil-exporting MENA countries’ economic policy
has focused on efforts to diversify their economies away from the hydrocarbon
sector. The results have been patchy: diversification into the petrochemical
industry has been quite successful for some countries (Saudi Arabia and
Kuwait, for example) but the price of petrochemical products tends to
be positively correlated with that of oil, which reduces the protection
it provides from the vicissitudes of the oil market. In general, the non-hydrocarbon
sector has largely been weak in oil-dependent MENA countries, and the
policy thrust has been how to expand the role of the private sector through
appropriate structural reforms.

Table 1. MENA Countries: Selected Economic Indicators,
1995-2002

1995

1996

1997

1998

1999

2000

2001

2002

Real Non-Oil GDP (percent)

Bahrain

4.2

3.7

3.0

3.7

2.9

4.1

5.7

4.9

Kuwait

3.4

3.1

4.1

3.1

1.0

1.1

0.5

1.1

Oman

5.0

2.8

6.1

2.6

-0.6

5.5

8.8

2.4

Qatar

-1.6

5.5

14.6

2.2

0.4

2.0

3.5

4.5

Saudi Arabia

0.5

1.0

4.5

2.6

2.8

3.9

2.5

2.9

United Arab Emirates

9.1

8.3

9.2

5.0

7.5

9.7

4.6

4.8

Algeria

4.0

3.8

-0.5

5.5

2.3

1.3

3.3

4.0

Egypt

...

...

...

...

...

...

...

...

Iran

3.5

6.2

7.1

3.8

2.5

4.9

6.7

7.4

Libya

-0.3

4.4

8.0

-5.3

2.6

5.1

2.5

2.4

Yemen

9.4

4.6

9.1

7.2

1.8

3.9

3.9

4.5

Non-Oil Fiscal Balance
(percent of GDP)

Bahrain

-17.5

-16.9

-17.6

-17.6

-17.4

-16.8

-18.1

-20.6

Kuwait

-39.2

-26.8

-22.2

-28.6

-23.9

-16.4

-20.2

-25.6

Oman

-33.9

-29.1

-28.5

-28.9

-28.0

-27.8

-31.0

-29.5

Qatar

-29.3

-37.0

-30.6

-31.9

-27.7

-18.0

-23.0

-14.2

Saudi Arabia

-27.8

-26.4

-28.4

-23.6

-23.3

-27.1

-30.7

-29.5

United Arab Emirates

-22.5

-26.1

-18.5

-20.1

-19.4

-15.4

-24.2

-26.3

Algeria

-23.1

-22.9

-26.3

-24.3

-25.8

-33.1

-31.5

-33.1

Egypt

...

...

...

...

...

...

...

...

Iran

-24.5

-21.1

-18.1

-15.1

-12.9

-16.8

-17.2

-23.7

Libya

-25.2

-29.2

-35.3

-30.9

-16.6

-30.9

-51.0

-105.2

Yemen

-17.0

-37.4

-31.8

-24.3

-23.3

-22.8

-24.2

-26.4

Oil Revenue (percent
of total revenue)

Bahrain

56.8

62.1

59.9

46.8

56.1

73.0

68.6

69.9

Kuwait

68.9

66.6

63.8

58.7

64.0

69.6

68.2

66.4

Oman

73.5

77.3

77.4

65.3

73.7

82.9

80.3

76.7

Qatar

61.9

68.8

64.5

60.0

71.1

78.4

70.9

72.0

Saudi Arabia

72.2

76.1

77.8

56.6

70.8

83.1

80.6

78.0

United Arab Emirates

55.8

56.9

58.4

41.5

43.7

55.7

58.8

63.3

Algeria

59.7

63.0

63.9

55.0

61.9

76.9

68.7

64.6

Egypt

...

...

...

...

...

...

...

...

Iran

65.2

61.5

53.6

35.8

42.8

67.5

57.4

58.6

Libya

62.2

69.6

66.5

57.6

50.6

65.2

64.8

82.0

Yemen

47.9

69.9

67.4

52.1

57.1

62.3

64.3

75.6

Oil and Gas Exports (percent
of total exports)

Bahrain

59.7

67.3

62.3

54.0

66.5

73.6

70.9

69.8

Kuwait

93.9

94.6

94.3

88.1

89.8

93.2

92.6

92.4

Oman

78.4

80.2

75.9

67.4

76.4

82.9

80.2

77.2

Qatar

65.0

67.3

68.4

74.9

84.8

86.7

85.5

84.2

Saudi Arabia

81.1

85.2

81.8

74.6

79.8

85.9

81.7

81.7

United Arab Emirates

46.1

49.2

44.6

37.5

45.2

54.6

48.4

45.7

Algeria

87.9

89.3

87.0

86.8

89.8

91.8

88.9

89.2

Egypt

48.3

48.2

33.7

22.5

35.6

37.2

28.7

31.0

Iran

78.4

75.0

67.7

47.3

63.4

84.3

70.7

73.9

Libya

...

...

...

...

...

...

...

...

Yemen

89.6

87.3

85.5

81.9

86.5

90.0

87.7

88.3

Source: Country data files.

In this context, the share of hydrocarbon revenue in total fiscal revenue
and export receipts continues to be quite large (see Table
1); the non-oil revenue base is quite small in many countries, reflecting
the small amount of corporate and personal income tax that is generated.
Indeed, in the GCC countries, personal income tax is virtually nonexistent
(limited to the Islamic tax or zakat levied at 2.5 percent of the net
wealth of individuals and companies) while the corporate sector is small
in most oil-dependent MENA countries. Furthermore, there are widespread
exemptions and tax holidays, large recurrent expenditures, and weak expenditure
controls—all of which have left the budget structure weak and vulnerable
to oil market variability.

Although the strong oil market performance since 2000 has enabled most
MENA net oil-exporting countries to improve their financial positions,
this state of affairs in the oil market cannot be taken for granted as
most forecasts indicate a lower price trend in the medium term. This underlines
the importance of reforms. A further indication of the need for reforms
is the level and behavior of the gross domestic debt and net foreign asset
position, which are unfavorable for some of the countries (see Figure
2). On the specific performance of the external sector, the huge oil
export receipts since 2000 have enabled MENA oil-exporters to build up
sizable net foreign reserves and, for some of them—such as the GCC
countries—has underpinned the stability of their currencies’
peg to the dollar in an environment of low inflation. This must be reinforced
through structural reforms to enhance the resilience of the economy against
unfavorable oil market developments.

The world oil market has undergone a series of changes that have reduced
the share of oil in the global energy balance and, with it, the influence
of Middle Eastern oil exporters. The era when oil producers had some control
of the oil market and could predict their oil receipts with some degree
of certainty has gone. The price of oil follows a random walk process,
which makes planning more difficult. In spite of oil’s loss of ground,
however, these countries remain at the center of world oil developments,
with the likelihood that the world’s reliance on the region will
increase in the long run as global demand grows and non-OPEC output declines.

The MENA oil-producing countries face a number of immediate challenges
related to oil’s dominant role in their economies and the risk arising
from the variability of prices. They have to accelerate their economic
reforms to reduce dependency on oil, including by promoting investment
and private sector growth, thereby creating jobs for their populations.
They must pursue prudent fiscal policies and save their oil revenue windfalls
at every opportunity to help cushion the impact of oil price declines
when they occur. Fiscal reforms designed to increase the resilience of
the budget to oil revenue shocks—such as a broadened revenue base,
reduction in unproductive expenditures, and civil service reforms—will
also play an important role. For some of the countries, such as those
of the GCC, labor market reforms also need to be accelerated.